Options are a tool that, when used wisely, can assist you in managing risk, generating revenue, and making predictions about the future path of the markets. Understanding them isn’t too difficult if you understand a few basic principles, despite the fact that they may initially appear obscure or hard to comprehend.
What Are Options?
Options are a derivative, implying that the underlying asset determines its value. This underlying asset may be a bond, currency, commodity, or stock.
It is a contract to exchange a financial asset, such as stock shares, at a specified price in the future. An options contract always involves two parties: one party creates the option (traders would say they “write the contract”), and the other party purchases the option.
- If required, the contracting party must purchase or sell the underlying stock.
- The party who purchases the contract gains the right but not the responsibility to carry out the transaction in the future.
Call and Put
Call and Put options, usually referred to as calls and puts, are the two main types of options.
- Calls provide buyers the right, not the responsibility, to purchase stock from the option writer in the future.
- Puts allow the buyer to sell shares to the options contract’s maker at a set price in the future. However, they do not obligate the buyer to do so.
How Do Options Work?
If you own only one security, say a stock, you might want to sell it at a different time for a higher price. It must be purchased for much less and sold for a higher one for you to benefit. However, as prices fluctuate, it is impossible to predict the average market price.
You can buy a put option to cover yourself against any potential losses. By doing this, you are able to sell the shares before or on the expiration date for a set price. An options contract is a type of insurance since no commitments are associated with it.
Another situation is when the stock market price is greater than expected in the days leading up to the expiration date. The contract would therefore be meaningless since you could just sell the shares in the market for a higher price. Thus, an options contract offers some degree of protection against market circumstances over which one has no control.
Hence, it is important to realize that options are all about evaluating the future price of security movements. An option that would profit from a certain event would be more expensive if the probability of that event, such as the price of security rising, were higher.
Advantages and Disadvantages of Options
Advantages
Low Costs
Compared to stock transactions, the primary benefit of options is that it enables the investor or trader to take a position with a smaller investment. When purchasing genuine stocks, you must pay a large sum of money. It is equal to the price of each stock multiplied by the number of purchased stocks.
Risk Protection
Your stock portfolio is well protected by using options. Purchasing them reduces your risk exposure by purchasing insurance for your stock portfolio. When a call option expires, it is worthless, and you lose everything you paid up front if the price of the underlying securities has not increased over the strike price. The highest level of your risk, however, is determined by the premium you ultimately pay.
Flexibility
The flexibility of trading options allows the investor to take advantage of any prospective change in the underlying security. An investor can employ an options strategy as long as he has a view of how the price of a security will change in the near future. An investor can purchase a call option and set the asset price at a specific level if he believes that the security price is likely to increase. Also, you can purchase the securities at the strike price and then sell them at the market price. This way, you can make a profit if the price increases.
Disadvantages
Less Liquidity
One of their major drawbacks is that options are not liquid due to the small number of traders in the options market. It is difficult to buy and sell options because of the low liquidity. Compared to other, more liquid investing options, this usually means buying at a higher rate and selling at a lower one.
Risks
As we’ve seen, there is just the option premium at risk when using options. An investor, however, risks losing the whole premium if the price movement of these investments is unfavorable.
Complex
For new investors, options are a challenging investing tool. Even for experienced investors, buying them can be a challenging task. A decision must be made on the price movement of a certain asset and the period by which this price movement will occur. As such, it can be difficult to get both correct.
Takeaways
- Options are a tool that can be used in managing risk, generating revenue, and making a prediction about the future of markets.
- There are two types of options: call and put.
- Call gives buyers the right to purchase stocks from the option writer.
- Put gives buyers the right to sell shares to the options contact’s maker.
- They provide low costs, flexibility, and risk protection to their users.
